Conclusion

In this chapter, we have examined the determination of household consumption under conditions of uncertainty, in conjunction with the determination of the allocation of the portfolio of the household among alternative assets (Samuelson [1969], Merton [1969]).

Under conditions of uncertainty, for a household that can borrow and lend freely in the capital market, consumption generally depends on the same factors as under certainty: the current and expected future rates of assets, the current and expected future labor income, and the total value of the portfolio and human wealth of the household.

Consumption does not depend on current household income but on total wealth, which consists of the value of its portfolio plus the present value of current and expected future labor income. In this sense, consumption smooths out temporary changes in income, as it depends on permanent or life cycle income (Modigliani and Brumberg [1954], Friedman [1957]).

However, the permanent income hypothesis cannot explain many of the features of individual or aggregate consumption patterns, especially the excess sensitivity of consumption to changes in current income. In addition, the consumption CAPM and the EMH, which are associated predictions of stochastic intertemporal models of consumption, seem to be refuted by the equity premium puzzle and excess volatility tests. The literature has thus examined models of behavioral finance, or models that result in precautionary savings, markets that are incomplete and households that are also subject to borrowing constraints (see Attanasio [1999]). Such models of consumption are quite diverse and complex. So far, they have not been adequately integrated into DSGE macroeconomic models. The financial crisis of 2008–2009 has, however, sparked a renewal of interest in financial market frictions. The literature on financial market frictions and their macroeconomic implications is introduced and discussed in chapter 19.

1. See Friedman [1957], or the “life cycle income” of the household in Modigliani and Brumberg [1954].

2. To understand stochastic models and decision making under uncertainty, one must be aware of the concepts of random variables and stochastic process, as well as the concept of rational expectations. Appendix F introduces random variables and stochastic processes in discrete time, and chapter 9 discusses the concept of rational expectations and solution methods of linear stochastic models under rational expectations.

3. See appendix E for methods of intertemporal optimization.

4. For a quadratic utility of the form u(C_t) = (1/2)C_t², it follows that u′(C_t) = C_t.

5. Because we assume that labor income risk is insurable, we concentrate on the case in which labor income Y is zero.

6. The more recent empirical literature on the permanent-income hypothesis is huge. Tests based on aggregate data include the original paper of Hall [1978], Flavin [1981, 1985], Hansen and Singleton [1982, 1983], Campbell and Mankiw [1989, 1991], and others. Attanasio [1999] surveys both aggregate and disaggregated studies.

7. See Merton [1973], Lucas [1978], and Breeden [1979]. The original CAPM of Sharpe [1964] and Lintner [1965] assumes that investors are concerned with the mean and variance of the return of their portfolio, rather than the mean and variance of consumption. That version of the model thus focused on so-called market betas, that is, coefficients from regressions of asset returns on the returns of a market portfolio.

8. See the important paper of Mehra and Prescott [1985], which has generated a large theoretical and empirical literature on this issue.

9. The roots of the EMH can be traced back to Bachelier [1900]. Its modern reincarnation is due to Fama [1965], Samuelson [1965], and especially Fama [1970].

10. See chapter 9 for the solution of first-order linear models with rational expectations, as is equation (10.41).

11. For a general treatment of asset pricing and the CAPM, see Cochrane [2005].

12. Behavioral finance is the application of psychology to financial behavior. For surveys of models of behavioral finance see, among others, Shleifer [2000] and Shiller [2003]. Thaler [2015] is a more general nontechnical introduction to behavioral economics, and Akerlof [2007] considers the implications of behavioral economics for macroeconomics (in particular, consumption and investment behavior, the Phillips curve, and Ricardian equivalence).